**by Bill Longbrake, Executive-in-Residence, Center for Financial Policy**

*This is an excerpt of the November 2013 Longbrake Letter. To read the letter in its entirety, click here.*

Over the last 50 years finance theorists extended the neo-classical economic theory of competition to financial instruments and markets. The neo-classical economic theory of competition is highly idealized and is based on rigid simplifying assumptions that are not consistent with observed behaviors. Financial economics theory is subject to the same limitations. However, the elegance of mathematical models that flowed directly from the assumptions and the utilization of these models in designing and pricing a plethora of financial instruments coupled with the fact that the models appeared to be reasonable in “normal” times, led many theorists and practitioners alike to blindly embrace the theory and models as accurate and complete. The theory dictates that market participants should seek to maximize value and based upon the theory’s assumptions, the operation of the market will assure that no participant benefits at the expense of another participant – the optimal collective outcome will always be achieved. In time this mantra of “the market knows best” came to dominate beliefs and behavior. Regulation was judged to be intrusive and unnecessary. In effect, Brock’s third pillar – the constitution/rule of law – was replaced with assumption that the market would do the job. Obviously, we know from hard experience that it did not.

**1. Neo-Classical Economic Theory**

Neo-classical economic theory was developed in the late 1800s and early 1900s. It is based on the theory of perfect competition, which results in the maximization of aggregate economic welfare. The theory is based on simplifying assumptions of human behavior that describe in broad general and ideal terms behaviors of participants in the economy.

Neo-classical economists understood that the real world is far more complex than the world assumed under the tenets of perfect competition. They realized that the actions of individuals do not adhere strictly to the simplifying assumptions. Nonetheless, the theory of perfect competition is a useful construct for understanding how an economy functions. By comparing the idealized assumptions to actual behaviors, economists and policymakers can better understand how to govern the economy to maximize aggregate public welfare, given the inherent self-interested and sometimes irrational behaviors of individuals.

**2. Rise of Financial Economics and the Efficient Markets Hypothesis**

Modern finance had its genesis in the 1950s. The defining event was Harry Markowitz’s doctoral dissertation on portfolio theory. Development of modern financial theory proceeded rapidly during the 1960s and 1970s and keyed off of the neo-classical theory of perfect competition.

**3. Assumptions of the Financial Economics Theory**

• All participants are rational

• All participants have access to complete information

• All participants share the same decision-making framework for using information to make decisions

• The decision-making framework is accurate and complete

All of these assumptions are oversimplifications of observed real world behaviors. The fourth assumption, if accepted uncritically, is especially problematic. What the term “accurate and complete” means is that the decision-making framework is stable and does not change over time. But that assumption is patently inconsistent with the rapid development of new financial technologies and the constantly evolving structure of the global economy and financial markets.

Financial economics theory posits that if all of these assumptions hold (which they do not), the collection of all individual decisions, which is “The Market”, will assure optimal outcomes both for individuals and the community as a whole. Thus, any form of intervention will lead to a suboptimal outcome.

**4. ****Operationalization of Financial Economics Theory**

Had financial economists been content to stay in the world of theory as had neo-classical economists financial economics theory would have remained a useful device for understanding the imperfect working of financial markets.

However, the theory, which assumes that financial events (phenomena) are random and normally distributed – both simplifying theoretical assumptions –, was operationalized through the development of market-traded financial instruments. The assumptions of randomness and normal distribution are a simplification of the fourth assumption that the decision-making framework is stable over time.

The famous Black-Scholes option-pricing model embedded the assumptions of randomness and normal distribution. This model was relied upon to develop pricing methodologies for a plethora of financial derivatives using historical data. The historical data were presumed to be normally distributed and to be stable over time. In other words, the pricing algorithms assumed that future price variability could be defined by and explained by past price variability.

These pricing models appeared to work well over a variety of market circumstances. As a consequence, the mathematical elegance of the model and the apparent accuracy of how it explained financial market behaviors strengthened the political movement toward deregulation and embracement of “The Market” as an effective and efficient market governance mechanism.

**5. ****Failure of the Theory of Financial Economics**

But, people lost sight of the reality that financial phenomena are neither random nor normally distributed. They lost sight of the reality that the model is not stable but ever changing as technological innovation and global competitiveness has evolved.

The macroeconomic consequences of growing income/wealth inequality had no place in the theory of financial economics.

Myopia and faith in the efficacy of micro financial theory blinded people to the building macroeconomic fragility.

There were warnings along the way that the assumptions underlying the construction and pricing of financial derivatives were deeply flawed. The collapse of Long Term Credit Capital, a mathematically-based arbitrage operation, in 1998 exposed the limitations of the assumption of normally distributed events. The reality was that the distribution had large fat tails in times of extreme duress. This hardly was a startling revelation. The centuries-long history of booms and busts and of speculation indicates that extreme events and fat tails are a natural occurrence in human existence.

Yet, the elegance of the theory and its operationalization led to uncritical belief in its efficacy. As financial markets embraced the theory and developed lucrative financial instruments based on it, self-interest entrenched commitment to its tenets and led to the capture of government policy and regulatory processes.

Thus, in this way modern finance theory contributed to rising income inequality and was a significant contributor to the escalation of unchecked market euphoria during the bubble years.

Perhaps disturbingly, in spite of the failure of the application of modern finance theory in recent years in governing market processes, the pricing of financial derivatives continues to be based on the simplified theory. Moreover, the beliefs, vested interests and political influence of the financial elite remain relatively unchanged.

It is in this vein that a debate about the future of capitalism is just beginning to emerge. The risk is that the debate will not develop into a substantive and critical evaluation of the causes of income inequality and the shortcomings of the application of simplified financial theory to the operation of financial markets. Without such an in depth assessment solutions, which have broad-based consensus, will not emerge. We have already witnessed the consequences of the current paradigm. So, clearly the status quo is not an optimal outcome. Indeed, adherence to the status quo could either lead eventually to social unrest and political reform under duress or alternatively it could foster the gradual decline in America’s economic, financial and political ascendancy.

**6. ****Asset Price Bubbles**

Asset pricing theory, which was developed by Myron Gordon¹, is based on the same general assumptions of financial economics theory. It posits that the price of an asset is determined by the discounted expected return of holding an asset for one

time period. This price depends upon three factors: any cash payment received during the period, the expected price at the end of the period and the discount rate. However, numerous studies have found that actual fluctuations in asset prices do not conform to the dictates of theory.

In a recent article, John Williams², president of the Federal Reserve Bank of San Francisco, quipped: “*We economists like to explain things using highly stylized models. We build make-believe worlds, populate them with creatures that act according to strictly prescribed rules, and analyze what happens. … Often the simplest model – with patently unrealistic assumptions – yields the keenest insights into how a market or an economy works. … Much of the research on asset prices continues to rely on highly stylized models with identical agents, rational expectations, and optimizing behavior*.”

If the assumptions of the theory held without exception, asset prices would never lead to price bubbles. In fact asset price bubbles form rather frequently. Williams states that the actual behavior of asset prices can be explained by replacing the assumption of rational expectations with people’s perceptions of what they believe will happen in the future. The record clearly shows that people’s expectations of the future depend on what has happened in the recent past. Thus, if prices have risen, the collective expectation is that they will continue to rise. This introduces a positive feedback loop that propels asset prices into bubble territory.

Williams concludes that asset price models need to incorporate an assumption of procyclical investor optimism and cites Charles Kindleberger’s seminal work: “*The lesson of history is clear: asset price bubbles are here to stay. They appear to be a consequence of human nature.*”³

*Dividends, Earnings, and Stock Prices*.

*Review of Economics and Statistics*41(2), pp. 99-105.

2. Williams, John C. *Bubbles Tomorrow, Yesterday, but Never Today?* *Federal Reserve Bank of San Francisco Economic Letter* 2013-27.

3. Kindleberger, Charles P. (1978). *Manias, Panics, and Crashes: A History of Financial Crises*. New York: Basic Books.